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Can profits be too high?

A recent blog post on the Socialist Economic Bulletin, published by ex-mayor of London Ken Livingstone, looked at the trend in the UK economy over last decade or more, for companies as a whole to invest significantly less than they are receiving in profits. SEB has consistently argued that investment in the UK economy has been weak for some time, and that it needs to rise in order for the recovery to be sustained and to benefit more people. It makes a case for the government to step in and raise public investment if the private sector continues to fail to increase its own investment. Michael Roberts has shown that a similar thing has taken place in the US, with record profits being achieved alongside an ‘investment strike’. He blames this on relatively high debt levels among small and medium-sized firms, and still insufficient profits among large firms. If firms have a high level of debt that they need to reduce, they may use some portion of profits to pay down this debt rather than invest more in new capacity. This is quite plausible.

Meanwhile, in Japan, as has been argued in a recent post on this blog, firms continue to run a substantial surplus (an excess of profits over investment) which for the economy as a whole, is not being spent on either new investment or returned to the household sector in the form of higher dividends or higher wages, both of which could arguably raise consumption and stimulate new investment in more productive activities. A similar process is taking place in South Korea, where wages and productivity are stagnating, while firms are sitting on huge cash hoards, although not as much as in Japan.

In all these cases, the question needs to be asked: are profits too high? Can they be too high?

If private sector investment in the various cases described above were to increase relative to profits, this could potentially raise productivity and output and therefore economic growth. But the question about profits being too high raises a further question: can investment be too high? After all, if much of the mass of profits is to be reinvested by firms, the productivity of that investment is important to determining the contribution that it makes to long-term growth.

Investment made by firms will prove to be productive if it provides the capacity to sustain the growth of consumption across the economy. In that case, the returns to investment will be sufficient to generate profits which can in turn fund further investment to support further growth in consumption. At the same time, the increasing productivity and output generated by rising productive investment allows growth in both profits and wages. Wages will need to grow to sustain consumption and justify new investment, unless household debt expands to fill the gap and, as we have seen in the Great Recession, this latter process cannot continue forever as debt eventually needs to be repaid. If we ignore the government sector (or if the government budget is always in balance), if rising household debt does not support consumption, and if wages do not grow as productivity grows, there will be rising savings in some part of the economy, either in the household sector and/or the corporate sector. If in this way savings exceed investment in the private sector, a trade surplus will be generated: exports will exceed imports, and this will impart a deflationary impulse abroad, as some other economy(s) will run an equivalent trade deficit (imports exceed exports).

Returning to our question: can profits be too high? Theoretically, if all income in a closed economy (with no external trade) flowed to profits and zero to wages, there would be no impulse to grow in the long run, as there would be no incentive to reinvest profits in new capacity to produce output which is consumed. Profits would ultimately collapse as there would be no consumption to sustain them. In this extreme case, profits are too high, but there is a mechanism to restore some kind of balance. If we drop our assumption of a closed economy, profits can remain high if a large part of the output is exported for consumption abroad. However in the rest of the world’s economy, which would be running a large trade deficit through its imports from the first economy greatly exceeding its exports to it, the position would again be unsustainable as debt in the rest of the world would grow inexorably, funded by the savings generated by the huge trade surplus and exported by the first economy. The overall position would be unsustainable. A real world example of this might be position in the run-up to the Great Recession between China (running a huge trade surplus and exporting savings abroad) and the US (running a fairly large trade deficit and importing savings which fuelled a housing and consumption boom which eventually collapsed). This position has been somewhat resolved in recent years, although it is not clear that the mechanism of resolution is optimal, as China massively boosted investment in infrastructure and housing in from 2009, which reduced its trade deficit, and this growth in investment may well prove to be unsustainable: growth in China is now slowing.

Another way that profits can be ‘too high’, I would argue, is when they exceed investment substantially over a long period, and the surplus flows in dividend payments to wealthier shareholders, who can then either reinvest them, or consume them. If they consume them, this would appear to be a way in which economic growth can be sustained in an increasingly unequal society. In my view, it would be better for growth and distribution if the ‘excess’ went towards wage rises, which could boost consumption more broadly and provide an incentive for new investment to produce output for and sustain that consumption. If wages were to rise too high relative to profits, the funds available for investment would fall, so clearly there is a limit to this more equitable path to rising prosperity.

Ultimately therefore, if productivity in an economy is rising and wages and other sources of consumption do not grow in line with potential output, either the economy has to run a trade surplus or budget deficit (boosting spending), both of which are unsustainable beyond a certain level in the long run due to rising debt, or profits can not be sustained at their current level and will fall, leading to a fall in investment and overall output and a growth slowdown or recession. So, to repeat: profits can be too high but there are economic mechanisms which will restore some kind of reasonable level in the medium to long run. These mechanisms may not be harmonious, and may lead to recession and unemployment, but that is the way capitalism tends to work. In the US and the UK at the moment, profits are only too high relative to investment, so it is investment that needs to rise rather than profits to fall. In Japan and South Korea, investment needs to become more productive, which would allow productivity, wages and consumption to rise over the longer term.

About Me

I have an MSc in development economics from SOAS, University of London and, while I now work for a charity, I remain passionately interested in the subject and how it can be used to promote sustainable human progress.
Apart from economics, I enjoy reading, walking, Qi Gong exercise, classical music, following professional tennis and athletics and spending time with friends and family. I also take an interest in politics, usually focussing on policy rather than personality, so that I don’t get too fed up with it.